Richard Thaler, professor of economics and behavioral science at the University of Chicago commented in a FT.com article about how the theory of Efficient Markets (otherwise known as EMH) led many to believe that the market should always be right. Hence, we have witnessed in recent years some gross policy errors and mistaken beliefs.
The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.
The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.
For many years the EMH was "taken as a fact of life" by economists. However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this "one of the most remarkable errors in the history of economic thought". The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.
Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. For example, stock market observers - as early as Benjamin Graham in the 1930s - noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance - the law of one price - and does not depend on any pricing model.
Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Michael Jensen's doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predictedfees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.
Now, a year into the crisis, where has it left the advocates of the EMH? On the free lunch component there are two lessons. The first is that many investments have risks that are more correlated than they appear. The second is that high returns that are based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist.
So where does this leave us? Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur.
While imperfect, financial markets are still the best way to allocate capital.
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